Swaps That Shook an Industry

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Swaps That Shook an Industry

• Proctor Gamble versus Bankers Trust

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History

• PG is an industrial company with over 30B in
  annual sales
• This case led to a 157M loss
• American rate swap
• German mark rate swap

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Why is This Case Important?

• Landmark court rulings
• Spurred accounting reforms
• Provided unflattering glimpses into Investment
  Banking through taped conversations of BTs
  bankers

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What is an Interest Rate Swap?

• Off balance sheet agreement
• Exchange of cash flows
• Generally medium to long term maturities
• Principal is notional
• Content Highlight 5.1 Page 132

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PGs Motivation for the Swaps

• Lower overall borrowing costs
• Expected 40 basis point gain on US deal
• No apparent reason for German mark deal

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Motives for Using the OTC Market

• Liquidity of the futures market
• Not marked to market
• Value of transactions reported off the balance
  sheet
• Losses would not have been so extreme had
  CBOT been used.

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The US Dollar Denominated Swap

• PG betting that US interest rates would fall
• Deal had 2 parts
• Plain Vanilla Swap
• The Speculative Side Bet

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Plain Vanilla Swap

• Notional principal of the deal was 200 M
• BT paid PG 5.3 fixed annual rate
• PG paid a floating rate tied to the average
  daily yield on 30 day commercial paper
• Nothing particularly unusual or risky

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The Speculative Side Bet

• PG sold BT the equivalent of a call option
• PG earned an annual premium of 75 basis points
  on the 200M notional principal
• Deal was structured irregularly so PGs
  liability was calculated on the spread between 30
  year bond price and 5 year bond yield

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German Mark Interest Rate Swap

• Deal was for 4.75 years and notional principal of
  93 M
• Not a cross currency swap
• 1st year of deal was considered odd
• BT pays German mark spot rate 2.33
• PG pays German mark sport rate 1.33
• Deal changed in second year

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German Mark Interest Rate Swap

• Current German swap rate was 5.35
• If it fell below 4.05 PG would make no payments
• It it rose above 6.01 PGs premium would change
  to 10X the difference between German mark swap
  rate and 4.50
• Exhibit 5.9 Page 143 The Wedding Band

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German Mark Interest Rate Swap

• US Federal Reserve tightened monetary policy
  leading to soaring international interest rates
• 2 weeks after PG had signed the deal rates had
  already exceeded 6.01
• PG was now responsible for payments rates of
  16.40 on the 93M notional principle
• Discounted present value of loss was 60.9M

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Lawsuit Against Bankers Trust

• PG suggested
• Breach of Fiduciary Duty
• BT Refused to Divulge its Pricing Model
• BT should have tracked the gains and losses on
  these swaps

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The Settlement

• PG agreed to pay BT 35M of the nearly 200M
  owed
• Both sides claimed victory
• Both sides caused collateral damage to their
  reputations

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The Landmark Court Ruling

• Swaps are defined as securities
• BT did not have a fiduciary relationship with PG

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Disclosure Reform

• US accounting standards for off balance sheet
  transactions were inadequate
• FASB and SEC developed reforms to make financial
  transactions more transparent to investors and
  regulators

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Conclusions

• PG carried most of the risk in this deal
• PG seemed incapable of tracking their market
  risks
• On a total notional principal of 300M, PG
  managed pre-tax losses of 157M